Housing, Credit Crunch, Oil Prices Spur Economic Jitters
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JIM LEHRER: Margaret Warner has our economy story.
MARGARET WARNER: It was a sobering assessment delivered by Treasury Secretary Henry Paulson in Washington today. The housing and credit crunch is the most significant current risk to the economy, he said, and shows no signs of ending soon.
HENRY PAULSON, U.S. Treasury Secretary: The longer housing prices remain stagnant or fall, the greater the penalty to our future economic growth. We must recognize the very real harms to families affected by the housing downturn. We must take steps to minimize the neighborhood effects and the macroeconomic effects of this housing market correction.
MARGARET WARNER: The problems began earlier this year in the so-called subprime mortgage lending market, which lent money to the riskiest of borrowers. Rising delinquency rates among them led to a wider credit crunch as lenders retrenched, and securities backed by these subprime mortgages saw their value plummet.
Paulson said today some 2 million subprime mortgages are due to reset to higher interest rates in the next 18 months, raising the prospect of many more foreclosures. All this, coupled with falling home prices, is having a real impact on our economy, he said, particularly in the construction sector.
Yesterday, the nation’s three largest banks — Citigroup, JPMorgan Chase, and Bank of America — announced the creation of a $100 billion fund to buy depressed asset-backed securities to keep them from being dumped on the market. The banks were prodded to do something by Paulson and other government officials, but at this point the fund includes no taxpayer money.
Another major cause for concern is the skyrocketing price of oil. It traded around $88 per barrel today. And the government is predicting home heating oil prices will soar 22 percent this winter.
So far, the broader job market seems to be holding steady, except in construction. The economy continues to create jobs at a modest pace, but U.S. industrial output was essentially flat in August and September. The stock market, which took a huge tumble in August, largely regained its footing after the Fed lowered interest rates, though it posted a significant loss yesterday.
Federal Reserve Chairman Ben Bernanke said last night that he expects further contraction in housing, and that is likely to be a significant drag on growth in the current quarter and through early next year.
For more, we get the perspective of two economists. Robert Shiller is a professor of economics and finance at Yale University. He’s the author of the 2000 book, “Irrational Exuberance,” and predicted the bursting of the dot-com bubble. And David Hale, the founding chairman of Hale Advisers, a Chicago-based economic consulting firm with private clients worldwide.
Welcome to you both.
Professor Shiller, do you agree with Secretary Paulson that, not only is the current housing crunch, credit crunch, not over, but, in fact, it’s going to continue to widen into broader areas of the economy?
The risk of recession
ROBERT SHILLER, Yale University: Well, I am among the more bearish economists, and this is something that I have been warning about for some time now. The housing boom that we've seen is the biggest housing boom in U.S. history, and it does seem to be slowing down, and it's turning down.
We've seen price drops of about 4 percent since the peak last year, and they seem to be going down. And I don't see any reason or any good or strong reason to think that it's over.
MARGARET WARNER: Do you think we're in risk of recession? And how do you define recession?
ROBERT SHILLER: Well, a recession is typically a sudden sharp slowdown in business operating over maybe a couple of quarters and then lingering after-effects for years. And are we on for a recession? It's really a cliffhanger right now. There's a lot of strong indicators, but the housing situation is weighing over us and creating enough anxiety that it could push us into recession.
MARGARET WARNER: And, David Hale, what's your assessment of the current economic picture and how worried we should be in the months to come?
DAVID HALE, Chairman, Hale Advisers: The reality is the U.S. economy is muddling along. Our growth rate, year on year for the second quarter, is 1.9 percent. But if you take away the housing sector, the growth rate is 2.9 percent.
We have clearly a major downturn in housing. In the year ahead, 2 million Americans could lose their homes to foreclosures, so this is an economic and social problem.
But the reality is, we have modest gains in capital spending. The consumer is still spending. And we're having an extraordinary export boom, because we have currently the strongest world economy in 1,000 years. Indeed, U.S. export growth is running at 13 percent, 14 percent, which is providing support for our manufacturing industry.
So the jury is still out whether we'll actually have a recession. We won't know, I think, for four or five more months.
MARGARET WARNER: Do you agree, though, that our conventional wisdom is right, that what's going on now was very much triggered by the subprime housing crisis?
DAVID HALE: There's no doubt that the subprime lies at the heart of the recent financial problems and the current crisis in housing. We had 12 and 18 months of growth, grossly irresponsible lending by a wide range of mortgage intermediaries providing credit to people who would never have qualified for it in the past.
And the result is we will have in the year ahead, next 18 months, 2 million people being foreclosed upon. We will probably have a default rate on the $1.3 trillion of subprime mortgage credit of 20 percent or 25 percent. The ultimate losses from this fiasco could approach $300 billion. And this has had a major effect on financial markets this summer, because it's created great uncertainty about how to value a wide range of securities which might include in their composition subprime credits.
MARGARET WARNER: So, Professor Shiller, the step that these three large banks took yesterday to create, to put up some money to essentially buy some of these mortgage-backed securities, how much will that do to ease that credit crunch and more broadly for the economy?
ROBERT SHILLER: Well, that's the big question. You know, you might say that there's not much substance to it. It's just some banks getting together and announcing that they're setting up a fund that would buy some of these troubled assets.
But these kinds of things have a possible impact on confidence. You know, it reminds me, back in 1902, J.P. Morgan -- that is the person J.P. Morgan -- set up a fund, a $50 million fund, to bail out the stock market. He did it again in 1907. And then, in 1929, J.P. Morgan did it. There's a long history of banks coming forth in times of trouble to announce plans to buy to protect the markets, and that's what's happening again.
Public confidence in the economy
MARGARET WARNER: So are you saying that the potential impact is at least as great just simply on public confidence as it is in real financial terms?
ROBERT SHILLER: Well, that's what I think it is. I think the problem is, is that the public has been generalizing from these subprime problems.
You know, recently there was worries about runs on banks. We saw what happened in the U.K. with Northern Rock. And there was a lot of fear that people had money in money market funds that might be invested in subprime. And it was creating a little bit of a panic situation.
So that's why I think it's -- we should commend these people for their public spirit. Maybe they have some self-interest in doing it, too. But this is the kind of thing that might possibly restore confidence.
MARGARET WARNER: David Hale, what's your view of the steps the banks took yesterday?
DAVID HALE: I think the steps announced by the banks yesterday are a step for Wall Street, not for Main Street. This new program by the banks will do nothing to address the core problem of millions of people defaulting on their mortgages and losing their homes. That problem is insoluble.
What it does, though, is provide a support for tradable assets in the financial markets. We had this summer what I would call a crisis of information. As a result of some Bear Stearns hedge funds going bankrupt, the markets lost all confidence in America's credit rating agencies. They decided the credit rating agencies had done a very poor job in evaluating these securities.
And we saw flight to quality. In six weeks, the commercial paper market shrank by $300 billion. Many of these securities become illiquid. And when they did trade, they traded at massive discounts to value. This is an attempt to try and restore liquidity to the market, to try and restore fair value for the higher quality securities.
MARGARET WARNER: Now, Professor Shiller, the other big factor looming over all of this or causing people anxiety is the continued rise in oil prices. What do you think is driving that? And what do you think is the potential ripple effect of that on the broader economy?
ROBERT SHILLER: Well, one thing that's been driving oil prices is a sense that the world economy is very strong and that, you know, the demand for oil is just increasing, steadily, with China and India and other countries growing.
But on the other hand, if you look at the futures market for oil, the futures market has been predicting -- I say (inaudible) -- that means predicting declines in oil now for some months. And so I think it's a temporary -- it's viewed as and probably is a temporary peak in the price of oil.
Industrial production indications
MARGARET WARNER: So, David Hale, the question is, if you look at, say, the industrial production figures, which were flat for August and September, do you take that as evidence or is there any evidence that these factors are starting to affect businesses' decisions, that is business decisions about investment?
DAVID HALE: Well, that's a very good question. We've had a major moderation in the last 12 months in the rate of growth in U.S. capital spending because of business uncertainty about oil, business uncertainty about the housing recession, also just uncertainty about monetary policy. A year ago, the Fed was still somewhat restrictive.
So a variety of factors have made business more cautious. And the fact that we have oil prices this week at $86 because of the danger of a Turkish attack on Kurdistan and just very low global inventories can only magnify that.
But the reality is, the strongest part of the capital spending numbers today were the business equipment sector. The capital spending part held up. What was weak was autos. And autos have been an ongoing consolidation, because of the U.S. companies' losing market share to the Japanese and Koreans, a larger, bigger structural problem in the whole U.S. auto industry.
So capital spending is still growing; it's simply in a modest pace.
MARGARET WARNER: And so, Professor Shiller, and then talk, too, about individuals. Consumer spending doesn't seem yet affected. How do you explain this discrepancy? I mean, if people's home values are dropping, some people are facing big hikes in their adjustable rate mortgages, yet spending, consumer spending, doesn't seem affected. What explains that? And at what point do businesses and homeowners start changing their behavior?
ROBERT SHILLER: Well, this is something of a puzzle. We also have a very strong stock market to explain. And so I think that maybe the best thing to bring up in this context is that the home price declines to date have not been very big.
According to the Standard and Poor Case-Shiller Index, which I'm involved in producing, home prices have only fallen about 4 percent since the peak last year. It's not a big drop yet. I think that this is a problem that may affect consumption in coming months or years, if it hasn't yet.
MARGARET WARNER: But what triggers -- I mean, what is the psychology of when people start saying, "Oh, I better not buy a new car"? What does that happen?
ROBERT SHILLER: Right, right. Well, my belief in this is that people don't respond very much to dry statistics or numbers. It's something that hits them in the gut, something that bothers them, scares them, worries them. And then they decide, "I'd better not spend more."
And I think the rising foreclosures and the stories of possibly more failed financial institutions are the kind of thing that could do that. I'm not saying it will do that, but that is the kind of thing that could get people to pull back.
The Federal Reserve's next step
MARGARET WARNER: And, David Hale, your view on that? Does it take something to strike -- does it have to strike individuals in the gut before they moderate their behavior?
DAVID HALE: I think we have to wait and see how far house prices fall. As Rob just indicated, we're down 4 percent year on year. The Chicago Mercantile Exchange now has a futures contract for house prices projecting in the year ahead a further price decline of 5 percent to 6 percent.
If that comes to pass, that means a price decline of 10 percent. A few bearish economists are warning about a 20 percent price decline. We can probably live with 5 percent; 10 percent is a challenge; 20 percent might finally set the stage for a consumer downturn.
The fact is, the whole situation is unprecedented. There has not been a decline in America's National House Price Index since 1933. We've had many regional downturns, very severe 15 years ago in Los Angeles, very severe 20 years ago in Houston. But we've not had since the Great Depression a year-on-year decline in the National House Price Index.
So we have no way to gauge when this event, when this process might finally tip over and give us a full-scale consumer recession. But I can assure you that's the issue the Federal Reserve is now watching by the day, because it will determine whether interest rates this winter fall 50, 100 or even 200 or 300 basis points.
And the further house prices fall, I think it would be fair to say, the further interest rates will fall. But we don't yet know how far this will go.
MARGARET WARNER: So very briefly, before we go, Professor Shiller, do you think the government, whether it's the Fed or the administration, is going to have to do more and, if so, what?
ROBERT SHILLER: Well, I think that we have to remember the homeowner, the small person who is caught up in this mess. And so I think that something like a bailout for these people, to either adjust the terms of their bankruptcy or to encourage lending to them through FHA, or Fannie or Freddie, are called for.
MARGARET WARNER: And David Hale?
DAVID HALE: I think it's very clear that we could have an expansion in Fannie Mae and Freddie Mac's balance sheet in the year ahead. Democrats in Congress are proposing 10 percent. The administration is more reluctant because of the accounting scandals there three years ago. But the fact is, Fannie Mae and Freddie Mac were created half a century ago for exactly this kind of purpose.
We could also encourage the security holders on Wall Street to have their bank intermediaries that credited these securities engage in renegotiation with lenders, to defer payments, to stretch out the time when mortgages get reset, things like that.
The problem though is, with the securitization process, banks no longer have the same relationship with borrowers they would have had 20 and 30 years ago. It's now far more complicated. But we could attempt, through negotiation, to try and help people facing big mortgage resets in the next 12 to 18 months to cope with this challenge, to get time, to get discretion to avoid having to default and go through foreclosure.
MARGARET WARNER: Which is exactly what Hank Paulson talked about today. Thank you both, David Hale and Professor Shiller.
ROBERT SHILLER: Pleasure.